An expensive accounting item

Why Greece’s Target-2 liabilities matter

by Frank Westermann

Fri 10 Jul 2015

The European Central Bank’s Target-2 balances have attracted wide attention, but they are still not well understood. Many people appear to believe that these intra-euro bloc assets and liabilities are no more than a nondescript accounting item in the maze of data of monthly central bank statements.

The Target-2 balances – under which the Bank of Greece currently owes the ECB around €100bn, a sum that has never been authorised or intensively discussed by any European parliament – measure the amount of liquidity provided by the Greek central bank to satisfy domestic needs.

More straightforwardly, this measures the amount of money that the Bank of Greece ‘prints’ (electronically) to finance Greece’s internal balance of payments deficit with the rest of the euro area.

Economists like Hans-Werner Sinn, who realised the significance of the Target-2 balances at an early stage, were right to point out the risks in case of a break-up of monetary union. To gauge the entirety of Greece’s exposure in the case of default and exit from the euro, Target-2 liabilities need to be added to the government’s public sector debt of €320bn. If Greece is declared bankrupt, these liabilities would be part of the bankruptcy estate.

Target-2 balances are thus likely to be in policy-makers’ minds when they meet this weekend to decide whether or not Greece stays in the euro area. If Greece were to depart, the remaining members of the euro system would have to write off corresponding claims.

Observers need to consider how the balances are created in the first place. When, for example, a depositor in Greece sends deposits to a German bank or buys a car in Germany, assets and liabilities are created which are relevant for countries' wealth.

In non-crisis times, as in the pre-2008 period, European deposits could just as easily be transferred across borders, but they did not create Target-2 claims and liabilities. This is because, when a Greek depositor sends money from Greece to Germany, the bank in Greece can sell assets to generate the liquidity needed to perform the wire-transfer.

In a state of equilibrium, these assets can be sold to the German bank which receives the deposits. Thus, in tranquil times, the wire-transfer of deposits is associated with a corresponding transfer of marketable assets from Greece to Germany, effectively balancing out the transaction.

In crisis times, the position is different. The Greek bank cannot easily sell its marketable assets, which are often Greek government bonds or non-performing loans. However, a Greek account holder can still send deposits abroad, because the Bank of Greece provides loans to the Greek bank at which the deposits are held.

This Bank of Greece emergency liquidity assistance (authorised by the ECB currently to a level of €89bn) creates a replacement for deposits and enables the transfer, with the depositor’s bank balance sheet remaining unchanged. Some might say that the Bank of Greece is preventing the sale of assets at ‘firesale prices’. A less benevolent interpretation – backed by many critics of ELA in Germany – would be that the central bank is simply delaying the insolvency of the banking system.

Only in the latter scenario, when the Greek bank doesn’t sell its marketable assets, are Target-2 balances created at both central banks.

It doesn’t matter whether money is printed to buy a Mercedes Benz car, to move deposits abroad, or to buy equity of the Daimler company. But it greatly matters whether Germany exports its goods and assets to Greece in return for other marketable assets.

Otherwise, the Bank of Greece creates an ELA credit that is translated, under an ECB-authorised process, into an indirect Bundesbank Target-2 claim on the euro system. The claim is open-ended with regard to both the amount and the duration. If a last-minute deal proves impossible and Greece is declared bankrupt, this could be very expensive.

Frank Westermann is Professor of Economics at Osnabrueck University and a member of the OMFIF Advisory Board. The Institute of Empirical Economic Research at Osnabrueck University regularly collects and reports Target-2 balances, as well as related literature, on the web page: www.eurocrisismonitor.com